A better way to tax billionaires

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OPINION – Unions are working to place an initiative on the November ballot that would impose a one-time five percent tax on the net worth of California residents in excess of $1 billion. Although it’s uncertain whether the proposal will make it to the ballot or withstand legal challenge, the Billionaire Tax Act has generated furious debate. Advocates claim that the tax will raise $100 billion over several years in needed revenue from billionaires who should pay their “fair share” to make up for federal cuts to health care and nutrition assistance. Opponents including Gov. Gavin Newsom worry that the tax would be unworkable and, amid reports that the proposal has already sparked a billionaire exodus, fiscally counterproductive.

California voters: If you really want to tax billionaires, there’s a better way: shut down the “buy, borrow, die” tax planning strategy whereby the very wealthy use loan proceeds to support their lifestyles without paying income tax.

Understanding this strategy requires a brief review of three longstanding features of our tax laws.

First, income taxes generally apply only to “realized” capital gains as opposed to “unrealized” appreciation. The rationale is that it’s unfair and impractical to tax appreciation absent a sale that generates cash with which to pay the tax.

Second, our income tax laws do not treat loan proceeds as taxable income (unless forgiven). An outstanding debt is a liability, not an asset or an accretion to wealth.

Finally, assets receive a “step-up” in tax basis to fair market value at death. The rationale is that this avoids administrative complexity and, in any event, assets held in larger estates are subject to estate tax.

These three features together enable an incredibly powerful tax avoidance strategy. A wealthy taxpayer can borrow heavily using as collateral appreciated assets such as a founder’s significant position in a large public corporation and use the proceeds to pay interest, support his or her lifestyle, or invest. The taxpayer has not received any taxable income. If the taxpayer holds the collateralized assets until death, any appreciation will escape capital gains tax and the assets will receive a step-up in basis in the hands of his or her heirs.

Even some fiscal conservatives will privately concede that the buy, borrow, die strategy, while technically legal, doesn’t pass the smell test. In tax policy speak, the “economic substance” is clear: ultra-rich folks are monetizing their appreciated assets – cashing out — without paying any tax toll. Moreover, it violates a basic tenet of good tax policy that taxpayers in similar circumstances should be taxed similarly. Why should two taxpayers who spend equal sums to support their lifestyle not pay similar tax on the source of that money, whether it’s proceeds from the sale of assets or a loan? After all, in either instance the taxpayer has cash to pay the tax.

There is a relatively simple way to address this disparity and raise significant revenue while avoiding the complexity and legal issues implicated by the Billionaire Tax Act: recharacterize some loan proceeds as sales proceeds — in tax terms, treat loan proceeds as the product of a “constructive sale” of the collateralized assets, resulting in a taxable capital gain.

Curtailing the buy, borrow and die strategy must be carefully tailored. We wouldn’t want to tax standard margin borrowing or smaller collateralized business loans. Thankfully, commentators have identified workable approaches based on factors such as the borrower’s net worth, the collateral used, loan-to-value ratios, whether the loan is recourse, whether the loan involves related or controlled parties, and the use of proceeds. The takeaway? This is absolutely doable.

Would this mark a radical departure from current law or policy? No. The constructive sale doctrine is already well-embedded in the Internal Revenue Code and its state counterparts. Notably, IRC Section 1259 imposes constructive sale treatment on certain hedging transactions that would otherwise result in a capital gains deferral. So this would be an extension of existing tax law doctrine, rather than something new and untested.

Yes, federal legislation would be preferable to maintain a consistent interstate playing field. Yet that shouldn’t preclude state action, particularly as a practical alternative to a potentially more harmful proposal. It’s not too late for Gov. Newsom to advance an alternative based on closing the buy, borrow, die strategy. Would it raise comparable revenue? No formal revenue estimate yet exists, but the likelihood is that it would raise more than a few billions to help fund California’s progressive spending priorities.

Andrew Sidamon-Eristoff, J.D. LL.M., is a former New Jersey State Treasurer, New York State Commissioner of Taxation and Finance, and New York City Commissioner for Finance.